A New Plan To Prevent Future Bailouts

Have you ever wondered if the government has a plan to avoid another financial institution failure, or if there's a bigger (or smaller), better bailout plan in the works? As luck would have it, the Federal Deposit Insurance Corporation (FDIC) has a new and innovative plan to handle the next financial institution failure and possible bank bailout.

Learning from Previous BailoutsThe main problems with recent bailout attempts included: taxpayer-funded bailouts, bankruptcy and insolvency, mergers, acquisitions and takeovers. Previously, American taxpayers funded the AIG bailout and the United States government emerged as a majority shareholder in the new AIG. With the AIG plan, it remained difficult to return ownership to private hands through orderly market operations.

When Lehman Brothers entered bankruptcy, there was widespread disruption and destabilization throughout the U.S. and international financial markets. After Bank of America acquired Merrill Lynch, federal regulators then realized that even when existing financial institutions have sufficient capital and adequate management expertise to take over failing companies quickly, they tend to create even larger, more complex financial institutions, which may not be the most desirable situation.

What Might Work for Future Financial Institution Failures?According to remarks by Martin Gruenberg, Acting Chairman of the FDIC, there is a creditor-supported, FDIC-guided plan to restructure, recapitalize and reprivatize the next systemically important financial institution to go by the wayside. Previously, the FDIC had limited powers and could only deal with insured deposit institutions.

The Dodd-Frank Act gives the FDIC the power to place non-bank parent holding companies into receivership. Once in receivership, the FDIC would create a new bridge company, and then would finally guide the newly capitalized company back into private ownership. The FDIC will appoint a board of directors and CEO to manage and operate the bridge company while restructuring takes place.

The Key Is in Shareholder and Creditor TreatmentThe difference in the new plan is how shareholders and creditors are treated. The FDIC resolution plan eliminates current equity positions in the failed company. Under the FDIC plan, subordinated and senior unsecured debt of the failed company become equity positions and some of the remaining debtors receive convertible subordinated debt claims in the newly created company. In effect, the FDIC decides, in advance, who the new owners and creditors will be. The new owners, i.e., former creditors, will then elect a new board of directors, who will in turn appoint a new CEO.

The newly created company is fully capitalized through debt-to-equity conversions and has established credit-worthiness and relationships through unsecured debt-to-convertible subordinated debt conversions. Additionally, and perhaps most importantly, is that the newly created company will emerge directly from receivership as a private, non-government owned entity.

Other Features of the FDIC Plan

Limited taxpayer losses: The Dodd-Frank Act allows the government to provide limited debt guarantees to a newly created company, instead of the traditional, taxpayer-funded cash infusion from the Treasury.

Government repayment provision: The Dodd-Frank Act also established the Orderly Liquidation Fund (OLF). Under the OLF, the Treasury Department may provide temporary liquidity to a company during the restructuring period, but the funds must be repaid through asset recovery from failed firms, or from assessments levied on larger financial institutions.

The "living will" requirement: Financial institutions with assets of $50 billion and up must have a resolution plan in place. The plan tells the FDIC how the company should be managed in the event of a failure. Plans for companies with assets exceeding $250 billion are expected as early as July 2012.

No deposit insurance: This may be the only downside of the plan. If the failing company is not an FDIC-insured bank, the FDIC will only operate as the resolution authority and will not extend deposit insurance to the parent holding company or any subsidiaries.

How Effective Will the FDIC Resolution Plan Be?The plan will take only the parent holding company into receivership, leaving any subsidiaries free to continue important operations in both the U.S. and international financial markets. Subsidiaries can operate with the confidence that the new parent holding company will already be privately owned and capitalized, and not subject to share price volatility as the government tries to sell its equity shares on the stock market.

The Bottom LineThe goals of the FDIC resolution plan are financial stability, accountability and viability for financial institutions that play a vital role in the overall health of the economy, and to the banking and financial systems. First, the plan facilitates financial stability by eliminating systemic risks that subsidiaries face when holding companies face liquidity problems. Second, the plan facilitates accountability because investors - both equity and debt holders - bear the losses of failed firms.

Accountability is further enhanced because taxpayers are essentially reimbursed through the asset recovery provision. Finally, the FDIC plan facilitates market viability because there is private market participation throughout the receivership process. If the FDIC resolution plan proves to be effective, then the government will avoid the next bailout through the use of a publicly guided, private-sector funded and managed workout agreement.